Reading the “Message of the Market?” Be Careful!

Does the market have a message?

Whether it does or not, there are hundreds of pundits who want to explain it!

There is an interesting contradiction.

If you believe that markets are efficient — carrying a message — then there is no edge for most of us in the investment business.  As Mr. Buffett says, he would be on a street corner selling pencils from a tin cup if markets were efficient.

If you believe that markets are not efficient — so that you can claim to have an investment edge — then you cannot infer a message when you have only noise!

Why is it that no one seems to realize this?  When the market is going in the direction of their prediction, people claim that "the market has learned how to interpret these rumors from Europe," just to pick one current example.

I am astonished by the current claims that the "bond market is smart" because it recognizes fears and the stock market should be thousands of points lower.  This might be true in normal times, but the current bond market is inhabited by millions of amateurs (the fearful), not the bond vigilantes of old.  Suggesting otherwise, as I hear every day on CNBC's Santelli report from the Chicago trading pits, is completely deceptive.

A Modest Proposal

I have a working hypothesis about the market message.  It is basically the opposite of what most other people think.  This is how sophisticated and experienced managers get an edge on the market.

  • On the "global macro" front, where everyone has an opinion and few bother to find the best sources, the market offers great opportunity.  This is the Warren Buffett  playground — open to the long-term investor.  Abnormal Returns has a great post on this subject.

"Let’s first stipulate that the financial markets are going to do whatever they darn well please. There is nothing any individual can do to affect the overall direction of the markets. Therefore active management is much like trying to play tennis against a professional player. This leaves the individual investor open not only to forced errors but unforced errors as well. The financial markets have a tendency to fool as many investors it can as often as it can. Can an individual investor score some points against the market? Sure, but the odds are that the market will on average return more volleys that you can’t handle."

I plan to add to this discussion, but this is really great advice.

  • On the stock and sector-specific front, especially in shorter time frames, it is important to watch the market.

This is one reason that technical analysis, at least in simple forms,  provides useful information.  Here are three current examples:

  1. We monitor price, volume, and technical factors through our "Felix" model.  Felix highlighted strength in home building last week.  We share these reports on Wall Street All Stars and also with those who subscribe to our reports.
  2. Felix also likes health care ETFs, an interesting move in front of the Supreme Court decision.  The market is expecting improvement in health care, which actually might happen simply from eliminating the uncertainty.
  3. Felix often highlights stocks in front of earnings reports.  This week Apollo Group (APOL) rocketed to a high position in our single-stock ratings. I chose not to play this in front of the earnings announcement, but Felix was right.  The point is that the market may seem to have information in front of important announcements.  Leaks?  Some people know?

It is well-established that trend-following methods are effective.  It all depends on the time frame and the setup.

Implementing the Message

Following the market trend is a staple for commodities traders.  Felix has an awesome performance in picking the Nasdaq 100, but there are some big drawdowns.  Few should take this approach, no matter how well it works.

For the long-term investor, most of what you read is unhelpful, misleading and costly.  Pretend that you are interviewing the pundit for a job.  You can ask the same question I do:

What can you tell me that I did not already read in this morning's Wall Street Journal?

The question needs to be updated, since the FT  is moving in.  The concept is still correct.

Most of what you read and hear comes from people who want to explain the day's trading as if they had predicted it.

 

 

 

A Closer Look at Current Survey Results

There has been a spate of pretty negative reports on business and consumer confidence.  Some people are very skeptical of surveys.  As a Michigan man who spent many hours at the Survey Research Center, I have respect for surveys that include strong design and execution.  Most of the complaints you hear come, as usual, from people who never took a single course in survey research.

I understand that the value of surveys can range widely.  Since some of the recent results (Philly Fed, the new Markit flash PMI, consumer confidence) are moving the market so dramatically, it is a good idea to take a deeper look.

I have been monitoring this theme for a long time, but some recent results are of special interest.  There are two key themes, explored below.

The "Us versus Them" Disparity

Responses to surveys vary dramatically depending upon whether the respondent is discussing his/her own situation or that of others.  I have many examples, all showing the same thing.  The results below are indicative.

  • McKinsey does a respected global economic survey.  There are many results that deserve your detailed consideration.  You can see the entire report if you do a free registration.  Here is the key point:

"…(E)xecutives remain optimistic about their companies’ prospects. Only 15 percent say customer demand for their companies’ products and services will decrease, and more than half expect profits to increase in the next six months. But this optimism does not extend across all regions and industries: larger shares in India and in the manufacturing sector now expect demand to decrease than did in March."

  • Businesses worry about others.  Here is a nice chart from the Duke survey of CFO's.  The difference between one's own company and the overall economy is obvious.  It has become a regular part of the economic landscape.

Optimism1

 

  • Personal spending expectations are down only slightly, despite the overall concern about others.

 

The "Future versus Now" Disparity

Responses vary dramatically depending upon whether the respondent is discussing current conditions or what he/she expects to happen in the future.  I have many examples, all showing the same thing.  The results below are indicative.

"While consumers’ expectations declined, consumers’ views on the present situation rose in June. Overall, the data suggest that there may be “little change” in the pace of near-term economic activity, Franco said."

  •  Businesses also worry about the future.

Here is what they say about their own business prospects:

“The Duke-CFO survey measures plans for the next 12 months, which is in contrast to the Bureau of Labor Statistics’ assessment of the employment situation, which measured a single month: May,” said Kate O’Sullivan, editorial director at CFO Magazine. “In contrast to the BLS number, CFOs indicate a level of hiring that would reduce the national unemployment rate to near 7 percent within a year, if all else remains constant.
“More than one out of four U.S. CFOs say their employees are maxed out, so the planned increase in payrolls is long overdue,” O’Sullivan said.

 But they are still worried about future conditions. 

Conclusions from the Data

When asked about their own situations, both consumers and businesses are more positive than when asked about others.  Which response do you think reflects the more informed reply?

When asked about the future versus now, both consumers and businesses see some comfort in future conditions but are worried about the future.  Which response do you think reflects the more informed reply?

I hope the answers to these questions are as obvious to readers as they would be to an expert on surveys.

The investment community looks at the "headline numbers" without asking much about the details. Businesses and consumers, despite their own success, read the same newspapers as everyone else.  The effect of the constant drumbeat of crisis stories has an effect.

Perceptions Become Reality

One of the key problems is that mistaken perceptions can become reality — a self-fulfilling prophecy.

There is plenty of evidence about this concern.

"Top executives are increasingly worried about potentially big changes in U.S. tax and spending policies in 2013— the so-called fiscal cliff — as well as the spillover effects of the financial crisis in Europe.

The Roundtable’s chairman, Boeing BA -0.17%  CEO Jim McNerney, said all the uncertainty is causing “paralysis” among businesses as the end of the year approaches. Some are even cutting jobs until they have a clearer idea of how the fiscal cliff and European crisis will be resolved."  (Marketwatch)

US businesses are moving funds out of European banks and taking other preparations. (Reuters).

Investment Conclusions

Two ideas leap out — and both are important.

  1. Conditions are not as bad as the headline numbers suggest.
  2. The failure of leadership is creating a negative climate.  Some of this failure can be laid at the doorstep of specific leaders, but much of it is a natural fallout of the US election cycle and the ongoing negotiations in Europe.

There is a danger that the delays in the political process will make things worse.  There is also an opportunity, since any change in perceptions could stimulate economic growth.  More confidence leads to more investment and more spending.

Monitoring this will help investors make decisions about cyclical stocks, tech stocks, and financials.  Recent favorites I have mentioned include CAT, AAPL, and JPM, but these are only examples.

Greek Election Preview for Investors

Whenever there is a big "binary" event, preparation is vital.  This happens in two different ways:

  1. Advance positioning.  These are specific trades to be done before the event occurs — deciding on asset allocation, sector allocation, and possibly protection against unlikely (but possible) outcomes.
  2. Tactical preparation.  The analysis must be done in advance, but the trades will occur after an initial outcome is announced.

The idea behind advance positioning is that you must not wait!  Whatever happens will move the market so much that you cannot possibly adjust.  This is often true in binary events like FDA decisions about new drugs, but it is not very true of events related to global macro.

On Wednesday night I listened (oh so briefly) with astonishment to the assembled punditry explaining why it was foolish to be "going long into the weekend" where the Greeks might exit the Euro.  The question we raised in our office was why was it not equally foolish to be short?

I guess we now have the answer, after two days of rebound.  Those who were so confident on Wednesday night have missed a big rebound.  It is not that I predicted the two-day trading move (although our Felix model caught it quite well).  What bothered me was the false, TV-inspired confidence of those "explaining"  the market on Wednesday.  As regular readers know, I believe that investors should be expecting a long-term solution in Europe.  This is a long-term prediction of a process of gradual compromise and negotiation, which you can check out here.

Tactical Positioning

If you do not think about problems in advance, you will be paralyzed at the wrong times.  My Wisconsin friends always talked about the "deer in the headlights" and the idea has caught on.

Here are some thoughts for advance planning.  This illustrates what I am doing.  You may feel free to disagree, but you had better have good reasons and be ready for some fancy footwork.

Greece is unlikely to exit the Euro

The reason is simple:  It does not really help any nation, whether inside Europe or outside.  This means that everyone will be trying to avoid this outcome.  Here is an excellent discussion from a great source, Credit Suisse’s Head of Global Research, Giles Keating.  In contrast to other pundits, please note that his background includes the analysis of politics as well as economics.

 

 

 

 

Keating believes that it would take a total breakdown for a return to the Drachma, and that much of the negative sentiment is built in.

An Eventual Solution — regardless of the initial decision

I like the thoughtful analysis from William De Vijlder, the chief investment officer at BNP Paribas Investment Partners (via Barry Critchley and FP Street).

“I am confident that a lasting solution will be found,” said De Vijlder, who spends his time when in  Europe between Brussels and Paris, in an interview in Toronto on Wednesday. De Vijlder, who has a Ph.D. in economics, bases his confidence on three main factors:

• There is knowledge of what needs to be done.

• There is the political will; and,

• It can be done.

The full article does a nice job of explaining each point.

The Market has Underestimated the Spain Plan

The market reaction is unsurprising, since the acid test is some sort of comprehensive plan.  Few in the financial punditry see the advantage of incremental improvement.  Here are some great points from one of our favorite sources, Peter Tchir of TF Market Advisors (via Financial Post).

I do not want to quote the entire (excellent) article, so here are my favorite points.  You really should read it all.

  • The plan will restore health of Spanish banks: A healthy banking system is necessary for a healthy economy, and official European investments will support investor investments in the medium- to long-term. “Over the next five years, this can pay off,” Tchir argues, and the rumored five-year moratorium on bailout repayments will give this time to happen. “I think [European lenders] will make decent investments, and investors will calm down,” adding that this could be a significant positive for Spain in the crisis.
  • Subordination of debt isn’t such a big deal: Thus, the risk of investments fleeing Spanish bonds because they are now subordinated to the preferred status of European lenders “is being overly hyped right now,” Tchir argues, though qualifying that investors shouldn’t be completely ignoring it. He believes that a much of this fear is rooted in the idea that Spain will actually be out €100 billion and misconceptions about where European cash is actually being invested.
  • Gives Europe time to get its act together: A reported 15-year repayment plan on loans to the FROB at just 3% interest means that Spanish banks are likely to remain afloat for a while as European leaders make more sweeping changes to the economic and political structure of the euro area.

Investment Summary

Your general takeaway should be that there will be an eventual solution, perhaps of the "muddle through" variety.

The worst case would be an election result with no clear winner and doubt about the ability to form a coalition.  The better cases would include a more probable path to a coalition.

In any case I expect plenty of skepticism and negative reaction — the prevailing sentiment.  There will be time to react, even for investors who have been cautious before the decision.

Here is a key precept for Monday:

Do not worry about a market reaction of 1 or 2%.  The stakes are much larger. 

A satisfactory solution could spark a major rally, since there are ripple effects for the US economy and corporate earnings.

An unsatisfactory solution will also require more analysis from many experts.